The TED spread represents the difference between the three-month Treasury bill and the three-month LIBOR based in U.S. dollars. In simpler terms, it is the differential between the interest rate for short-term U.S. government debt and the interest rate for interbank loans.
TED is an acronym for the Treasury-EuroDollar rate.
Key Takeaways
- The TED spread is the gap between the three-month LIBOR and the three-month Treasury bill rate.
- It’s a commonly used measure of credit risk since U.S. Treasury bills are seen as risk-free.
- This spread often widens during economic crises and narrows during periods of economic stability.
Delving Deeper: What is the TED Spread?
Originally, the TED spread was the price difference between three-month futures contracts on U.S. Treasuries and three-month contracts for Eurodollars with the same expiration months. Post the 1987 stock market crash, when futures on Treasury bills (T-bills) were dropped by the Chicago Mercantile Exchange (CME), the calculation was amended. It now measures the difference between the interest rate banks charge each other over three months and the rate at which the U.S. government borrows money for the same period.
The TED spread is a vital indicator of credit risk. U.S. T-bills, considered risk-free, establish the baseline for comparison. LIBOR, being a benchmark reflecting the rates at which large international banks lend to one another, provides a measure of corporate borrowing credit risk. Thus, comparing these rates gives an insight into the market’s perception of credit risk.
Due to regulatory changes, by the end of 2021, banks transitioned away from using LIBOR for new contracts, and by June 30, 2023, existing contracts had to follow suit.
As the TED spread rises, it signals an increasing default risk in interbank loans. Higher liquidity or solvency risks necessitate higher interest rates on these loans. Conversely, as the spread narrows, default risk decreases, encouraging investors to move from T-bills to stocks, seeking better returns.
Calculation and Real-World Example
Formula
TED Spread = 3-month LIBOR - 3-month T-bill rate
Calculation Example
If the T-bill rate is 1.43% and LIBOR is 1.79%, the TED Spread would be:
TED Spread = 1.79% - 1.43% = 0.36% (or 36 basis points)
Typically, the TED spread fluctuates between 10 and 50 basis points. However, during economic crises, this spread can widen significantly. For instance, following the collapse of Lehman Brothers in 2008, the TED spread skyrocketed to 450 basis points, reflecting the heightened default risk and resulting restrictions on interbank lending.
Related Terms: Three-Month Treasury Bill, Three-Month LIBOR, Credit Risk, Default Risk, Interbank Loans.
References
- Intercontinental Exchange. “LIBOR®”.
